What are Zero Coupon Bonds? Who Should Invest in Them?

Bonds have been around much before shares were available to investors. Companies used to raise funds with a written guarantee of the promise to pay it back in full with interest. This guarantee is known as a bond. In India, bonds can be broadly classified as Government Bonds and Corporate Bonds.

Zero Coupon Bonds

A coupon is a periodic interest received by a bondholder from the time of issuance of the bond till maturity. Zero coupon bonds, also known as discount bonds, do not pay any interest to the bondholders. Instead, you get a large discount on the face value of the bond.

On maturity, the bondholder receives the face value of his investment. In simple words, the investor purchasing a zero coupon bond profits from the difference between the buying price and the face value, contrary to the usual interest income.  

Yield to maturity of Zero Coupon Bonds

Zero coupon bonds can work wonders, if used meticulously and in sync with your investment goals. In the absence of any intermittent coupon payments, the yield to maturity of a zero coupon bond is calculated as below:

(Face value/ current market price)*(1/years to maturity) – 1  

Who should invest in Zero Coupon Bonds?

The basic definition of these bonds indicates the absence of regular interest payments to investors. You must keep that in mind before opting for them. These are ideal for people who would require funds at a specific period of time in the future like children’s education or retirement or a planned tour.

Also, if you are not interested in watching the market trends and like the comfort of the ‘invest and forget’ strategy, then you can consider zero coupon bonds. If your investment portfolio primarily consists of growth investments and you are looking to add diversity to it, then zero coupon bonds can help you secure a guaranteed return for a fixed time period.

Finally, these bonds tend to offer great discounts for longer tenures of investment and are perfect for long-term investment plans.  

Risks involved with investing in Zero Coupon Bonds

Zero coupon bonds are subject to interest rates risk if sold prior to the date of maturity. The value of this bond is inversely related to the rise in the interest rates; with rising in interest rates there is a decline in the value of these bonds in the secondary market. The sensitivity of long-term zero-coupon bonds to interest rates exposes them to duration risk.

This means that higher a bond’s duration, the greater will be its sensitivity to interest rate changes. Note: Duration risk is the risk that is associated with the sensitivity of a bond’s price to one percent change in the rate of interest.

Investment horizon for Zero Coupon Bonds?

Long-term zero coupon bonds are generally issued with maturities of 10 to 15 years. There is an inverse relationship between the time and the maturity value of a zero coupon bond. The longer the length until a zero-coupon bonds maturity date the less the investor generally has to pay for it. Zero coupon bonds with a maturity of less than a year offer a short-term investment option.  

Advantages of Zero Coupon Bonds?

Bonds are usually compared with other fixed income options by investors looking for minimal risks. As compared to other fixed-income options, these bonds offer good returns on maturity while keeping the option of selling them on the secondary market open, if the interest rates decline sharply.

Another important feature of notified zero coupon bonds is that investors do not have to pay any tax on interest since the bonds are issued at a discounted price and redeemed at face value. They are only subject to capital gains tax.

Tax on Gains: How is income from these bonds treated?

As mentioned above, investors of notified zero coupon bonds issued by NABARD and REC are liable to pay only capital gains tax on maturity. Capital appreciation in such cases is the difference between the maturity price and purchase price of the bond. In case of non-notified zero coupon bonds, the difference between maturity and purchase price is treated as interest and taxed accordingly. 

Like the growth market, the fixed income security market should be approached with a clear understanding of your investment goals and horizon. Zero coupon bonds can work wonders if used meticulously and in sync with your investment objectives. Note: Apart from NABARD, only a few Government Organizations with the approval from the Finance Ministry are authorized to issue zero coupon bonds.

Approvals require annual revalidation if not utilized during the notification year. For more investment related queries on zero coupon bonds reach out to our experienced finance professionals at ClearTax today.